What is the Difference Between Stocks & Bonds?

Function

Both stocks and bonds are issued to raise capital, but do this in different ways. Corporations are legally restricted to using money raised through bonds to fund short-term operations. They issue one-month or three-month bonds to raise a specific amount of money to run the business for that period, and then pay back the bonds at interest with the revenue from business activities. Issuing stocks involves valuing the entire company and breaking it up into equal shares. The capital raised by issuing stock is not paid back and is unrestricted in its use.

This issue of paying back the loan of capital means time is a factor in bonds. Corporate paper is by definition short term. State and national governments also issue short-term bonds, called bills, but also fund themselves through the issue of long-term, 10- and 30-year, bonds. Stocks, on the other hand, do not involve amortization and do not have an expiration date, usually existing for the life of the business entity.

Stocks and bonds both factor credit risk into their pricing, but do so differently. The greater the credit risk a company or entity poses, that is, the more likely it is to be unable to pay its debts, the lower its stock will be worth. Equity investors will begin to factor the default risk into the price of a company's stock, unwilling to take the risk of being wiped out entirely. Bondholders, on the other hand, can benefit from higher credit risk companies, since defaults on corporate paper are relatively rare occurrences. Because of the higher risk, these companies are forced to pay a higher interest rate to obtain funding, and this translates into additional revenue for the bondholder.

It does happen, however, that companies go bankrupt, and in that event, the equity of shareholders could be wiped out entirely. Bondholders, to varying degrees, will be made whole in order of seniority. Stocks carry partial ownership in a business, whereas bonds do not. Instead, bonds make an investor a creditor in a business. In the event of a buyout, the acquiring company assumes all the debt of the acquired company, meaning it covers the payments to the bondholders, and issues shares of itself to equity holders.

Stocks provide a way for capital investors to tap into the explosive growth potential of individual companies and economies. Conversely, they pose significant risk when economies contract. Bonds often function precisely opposite, with investors flocking in times of uncertainty to the guaranteed return of capital through secure and highly rated paper such as Treasury bills and general obligation municipal bonds.